Opening China

FOR a country which appears to pride itself on financial opacity, China’s actions over its devaluation of its currency are intriguing. Why so transparent?

China could have followed a Singapore-style path, moving to a managed basket where the weights and policy bands are kept secret. This would have allowed it to shift its currency from the dollar peg (quickly or slowly) while encouraging greater flexibility in exchange rate policy and, crucially, some realignment against the other regional and global currencies.

Such a move would also have discouraged the “continued expectations” dilemma that small explicit devaluations tend to encourage while putting China on the path to the ultimate goal of full flexibility.

But China’s actions point to a more base motive. When faced with fear, people tend to first freeze then panic. Prior to last week’s “first yuan devaluation for 21 years” headlines, the daily People’s Bank of China fix was broadly frozen for several months.

That fear of course emanates from the performance of the dollar in the face of less easy US monetary policy. The explicit dollar peg has led to the yuan appreciating by some 14 per cent in recent months; enough to trouble any exporting behemoth.

But that mercantalist tale is not the whole story. The People’s Bank’s balance sheet is where the real story lies. Around 80 per cent of its assets are foreign exchange reserves. Any balance of payments’ imbalance – capital ouflows – leads directly to a fall in the bank’s assets, a contracting balance sheet and therefore tighter domestic credit.

Now ask why reserve requirements have not been slashed and think: capital flight. Whilst China had vast BoP surpluses and the dollar was weak and US monetary policy was easing, China’s monetary management was relatively easy. The situation is now the polar opposite.

China faces a heavily indebted, slowing economy which needs capital inflows to maintain or at the very least orchestrate an orderly unwind of domestic credit. Capital outflows are a disaster.

Putting the devaluation genie back in the box is well nigh impossible. If the global cyclical divergence continues and the euro slips, the pressure on China will only intensify and encourage expectations of further devaluations and further capital outflows. China has played the transparency card at exactly the wrong time.